Paychex Inc. (PAYX) reported fourth-quarter fiscal 2011 earnings of 33 cents per share, which came in line with the Zacks Consensus Estimate. Though the quarter’s results indicate an improving client retention rate and higher checks per client, lower sale of new units remains an overhang.

Revenues

Paychex reported fourth-quarter 2011 revenues of $522.7 million, which missed the Zacks Consensus Estimate of $542.0 million, but increased 5.3% from $496.2 million reported in the year-ago quarter. The revenue upside can be attributed to year-over-year growth in both checks processed per client and the HR services client base.

Payroll Service segment revenue increased 4.6% from the year-ago quarter to $356.9 million, attributable to the contribution from SurePayroll Inc., acquired in February. Excluding the SurePayroll contribution, Payroll revenue would have grown only 3.0%.

Continued growth in checks processed per client as well as revenue per checks also added to the growth. However, the increase in new unit sales was sluggish, due to the limited number of new companies commencing business during the quarter.

The Human Resource Services segment generated $153.5 million in revenues, up 8.7% from the prior-year quarter. The improvement was partly due to the contribution from ePlan Services, which was acquired in May. The number of client employees served and the number of clients grew during the quarter, contributing to the increase. Moreover, demand for a new product, HR Essentials, also added to the segment’s revenue growth.

Operating Results

In the fourth quarter, Paychex incurred total operating expense of $339.9 million, up 5.4% from the year-ago quarter. The increase was mainly due to acquisition-related costs as well as the company’s continued efforts to train sales personnel, provide better customer service and enhance technological infrastructure. However, the increase was partially offset by a higher utilization rate and lower headcount.

Operating income was $182.8 million, up 5.3% from the year-ago period, attributable to modest revenue growth and better cost management. Operating margin remained flat year over year at 35.0%.

Net income of $118.9 million in the reported quarter reflected a 2.9% increase from $115.5 million in the prior-year quarter. Net income per diluted share was 33 cents compared with 32 cents in the year-ago quarter. There was no one-time item during the quarter.

Balance Sheet & Cash Flow

Paychex exited the fourth quarter with cash and cash equivalents of $119.0 million, down from $236.0 million at the end of the prior quarter. The lower cash balance was due to cash used up in investing and financing activities. Corporate investments increased $111.3 million sequentially to $345.0 million.

Additionally, interest on funds held for clients decreased 10.2% year over year to $12.3 million as a result of lower average interest rates earned, partially offset by an increase in average investment balances. Paychex has no long-term debt.

Cash from operations was $162.4 million compared to $335.5 million in the prior quarter. Capital expenditures were $21.5 million compared to $34.9 million in the prior quarter.

Guidance

For fiscal 2012, Paychex expects a 5–7% increase in Payroll Service revenues compared to the year-ago quarter. Human Resource Services revenues are expected to increase in the range of 12.0% to 15.0%.

Total service revenue is likely to grow in the range of 7% to 9%. The company expects a 12–14% decline in interest on funds held for clients and a roughly 2% increase in net investment income.

Interest on funds held for clients and investment income for fiscal 2012 are expected to be impacted by the low interest rate environment. However, investment of cash generated from operations is expected to continue, so investment income will increase.

Net operating income is expected in the range of 35–36% of total service revenue. The effective tax rate is expected to be roughly 35% and net margin is projected at between 5% and 7%.

The guidance for fiscal 2012 includes anticipated results from Paychex’s recent acquisition of SurePayroll Inc. and its ePlan Services. The acquisitions are expected to have approximately a 2% positive impact on revenue, nonetheless resulting in earnings dilution of around 1 cent per share due to amortization on acquired intangible assets and some one-time acquisition costs.

Our Take

The fourth quarter has been lackluster over the past few years, relative to the other three quarters. Although results matched the company’s guidance in the fourth quarter of 2011, we are disappointed with the top line, which was well below our estimates.

However, we remain positive on management’s positive commentary regarding continued investments in product development and synergies from the recent acquisitions. We also believe that cost control measures will remain catalysts for Paychex, going forward.

We remain concerned about lower interest rates, lackluster new business formation and growing competition in the outsourcing space from big players such as Automated Data Processing Inc. (ADP) and Administaff Inc. (ASF).